Physician Tax Planning and Investment Vehicles
It is essential for new physicians to understand the structures and tax-advantages of different employer-offered retirement plans. When you sign the employment contract for your first attending position, your financial situation can transform dramatically overnight. Along with a substantial raise, you can expect a considerable increase to your tax burden. To evaluate an employer’s retirement offerings and navigate this new financial territory, physicians need to know the most common employer-sponsored retirement plans.
Before delving into the different types of employer-offered retirement plans, it is important to understand two factors that influence the value and limitations of each plan.
The first factor is employer-match programs. Some employers will match employee retirement contributions based on a percentage or dollar-for-dollar amount. In most cases, matching employer contributions do not count towards annual limits. These matching programs are highly valuable to physicians, as they essentially offer free money for your retirement.
Second, some plans are subject to a vesting schedule. A vesting schedule determines when an employee can claim full ownership over employer-contributed funds within their retirement plan. As you continue working for an employer, your percentage of ownership will increase until you are 100% vested. If you leave the company before you are fully vested, you may forfeit some of your employer’s matching contributions. You will always maintain full ownership over the funds that you personally contributed.
Carefully consider these factors when you consider the value of an employer’s retirement plan. If you overlook a matching program, you may miss out on free money. If you ignore a vesting schedule, you may be surprised to see your retirement funds take a hit when you change employers. Bearing these features in mind, we can now explore the most common types of retirement plans for physician-employees:
Traditional and Roth 401(k) plans
401(k)s are a common investment plan for physicians who are employees of for-profit organizations or self-employed. Physicians can make elective salary deferrals to their 401(k)s, diverting a chosen amount of money from their paycheck into their retirement savings. In 2020, the maximum annual contributions for a 401(k) is $19,500 or $26,000 for physicians over the age of 50.
Traditional 401(k) plans are contributed with pre-tax dollars, and qualified withdrawals are taxed as ordinary income. Because physicians are typically high-earners, maximizing annual 401(k) contributions is a strongly advised tactic to reduce one’s taxable income.
In addition to a traditional 401(k), some employers also offer Roth 401(k)s. Contributions into Roth 401(k) plans are made with after-tax dollars. As a result, qualified distribuFtions from a Roth 401(k) are tax-free during retirement. In both a traditional and Roth 401(k), your investment dollars can grow tax-free within the account and non-qualified withdrawals before the age of 59½ may be subject to a 10% penalty.
Very similar in structure to 401(k)s, 403(b) plans are offered to employees of government and non-profit organizations. Because most hospitals are nonprofit entities, the majority of hospital-employed physicians will have a 403(b) retirement offering. 403(b) plans have the same annual contribution limits as 401(k)s, and salary deferrals can be made on a pre-tax or Roth basis, provided that your employer has a Roth offering.
Some hospital systems also offer employees a 401(a) plan, also known as “money purchase plans.” Unlike 401(k)s and 403(b)s, for which the employee chooses contribution amounts, 401(a) plans allow the employer to determine the contribution rules. Contributions to the account can be made by the employee, the employer, or both. Typically, 401(a) plans include annual employer contributions; employees then gain ownership of these contributions over the course of a vesting schedule. In this way, 401(a) plans are often used to incentivize employee retention.
Employers can set a mandatory 401(a) contribution amount for employees based on a percentage of income or a flat-dollar amount. For example, an employer could require all employees to defer 5% of their pre-tax salary to their 401(a) plan, and commit to matching this amount with an employer-funded contribution. While employees have immediate ownership over their own 5% investment, a vesting schedule may require employees to remain with the employer for a certain number of years in order to gain ownership of the employer-funded money in the 401(a). Once vested, physicians can transfer 401(a) funds to a 401(k), IRA, or alternative qualified retirement plan. Physicians may also withdraw 401(a) funds through a lump-sum payment or annuity.
Typically, 401(a) salary deferrals are made with pre-tax dollars, and thus contributions are tax-deductible. Similar to a 401(k), qualified 401(a) distributions are subject to income tax, and the IRS imposes a 10% early withdrawal penalty if the account holder is less than 59 ½ years old.
Certain government healthcare organizations, as well as non-governmental organizations (NGOs), offer 457(b) plans. These plans share the same tax-advantages and annual contribution limits as a traditional 401(k). However, unlike 401(k) and 403(b) plans, if your employer offers a matching 457(b) contribution, the value of their contribution does count towards the annual contribution limit.
Notably, 457(b) plans do not impose a penalty on early withdrawals. This feature is highly beneficial if you believe you may retire early or require access to retirement funds before the age of 59 ½. 457(b)s are particularly valuable to physicians if offered in conjunction with a 403(b) plan. In the event that a physician has already maximized their annual 403(b) contribution, they can reduce their taxable income and build their savings even further by contributing to a 457(b).
While balances from a government-sponsored 457(b) can also be rolled over into IRAs or other employer-sponsored retirement plans, the same is not true for NGO-sponsored non 457(b)s. A final caveat: NGO-sponsored 457(b) plans present a substantial risk of forfeiture. If the sponsoring institution declares bankruptcy, you could lose all funds within your plan. Before jumping to this, consider diversifying other tax-free and tax-favored retirement savings options so that you have access to both tax deductible/tax-deferred and tax-free accumulation.
Utilizing employer-sponsored retirement plans is an important first step to build your savings and manage your tax burden. While many of these plans share a similar structure, there are also important distinctions that will affect how and when the funds can be used. Depending on the tax benefits of your plan, you may receive either an immediate tax deduction with tax-deferral or tax-free distributions during retirement.
Physicians are advised to maximize annual contributions to employer-sponsored retirement plans and take advantage of any employer-match programs. However, it is important to note that these plans alone are rarely sufficient to provide for a physician’s retirement income, and therefore they should be paired with personal investment vehicles such as IRAs, stocks, bonds, mutual funds, ETFs, index funds, cash-value insurance contracts, or real estate.
For more information on physician tax-planning, employee benefits, and retirement planning, talk with one of our trusted advisors today.